A recent case offers a fresh reminder that directors must satisfy their fiduciary obligations when setting their own compensation.

In a derivative action against the non-employee directors of OvaScience, Inc., a stockholder alleged that the non-employee directors had breached their fiduciary duties and wasted corporate assets by paying themselves excessive compensation. In 2015, for example, all of OvaScience’s non-employee directors received compensation of at least $300,000 (substantially all of which represented the fair value of equity awards granted during the year), and two directors received more than $500,000.

Under Delaware law, OvaScience’s directors had the authority to set their own compensation, but they were nonetheless required to satisfy the heightened fiduciary standards applicable to transactions in which they have a conflict of interest. In such a case, interested directors bear the burden of proving that the transaction is “entirely fair” to the corporation – typically a high bar to meet – unless the transaction is approved by an informed vote of the stockholders or disinterested directors. Because directors would rarely be considered to be disinterested in their own compensation, companies whose director compensation is not approved by stockholders are vulnerable to allegations that their director compensation is not entirely fair.

Rather than fight the allegations, OvaScience and its directors chose to settle. OvaScience agreed to implement new policies and practices for its director compensation, including an agreement to submit to a vote of stockholders a binding proposal to approve its director compensation plan. Among other things, OvaScience agreed:

to cap annual compensation for incumbent directors at $300,000

to cap annual compensation for new directors at $600,000

to impose a holding period on new equity grants, which would expire on the earlier of termination of director service or seven years after grant

to base future adjustments to director compensation on a current peer group assessment and current “best practices”

to submit for stockholder approval any changes to the annual limits or the holding period

to submit the director compensation program for stockholder approval at least once every three years

Not surprisingly, the compensation for OvaScience’s non-employee directors in 2018 was down significantly from 2015. Five directors received compensation of less than $82,000 each, and two others received compensation of less than $183,000 each. Stockholders readily approved the new compensation plan in June.

To avoid similar challenges to director compensation, public companies should consider whether to seek stockholder approval of their director compensation plans or should ensure that those plans fall well inside the range of similar plans for a valid peer group. While the latter course won’t necessarily insulate a company from a derivative claim, it should diminish the likelihood that one will be successful.

Companies might consider additional steps to help insulate director compensation. For example, companies could submit for stockholder approval new or amended equity compensation plans that include a meaningful cap on grants to directors. Interestingly, we have not yet observed a resurgence of the old practice of embedding formula grants for directors into a stockholder-approved plan, pursuant to which a fixed number of shares or a fixed dollar amount is granted to directors annually. While that approach should be less vulnerable to challenge, it would eliminate important flexibility that many boards value when setting compensation.